How ETF Prices Are Determined

Notes on how ETF prices are determined

I've been researching emerging market ETFs lately, and I suddenly wondered how ETF prices are actually determined, so I looked into it.

By the way, knowing this mechanism doesn't seem to improve investment performance,so it's really just a bit of trivia...

How ETF prices are determined

1. ETFs always have a benchmark index

→ In the case of passive ETFs, they are structured to track stock indices like the S&P 500.
→ In the case of active ETFs (like ARK), they determine and publish their own benchmark index.

2. The ETF company publishes a PCF

ETF companies do not have traders and do not buy or sell stocks themselves.
The ETF company publishes a Portfolio Composition File (PCF), which is a list of the individual stocks that make up the ETF.

* It's like saying, "Here is what's inside the lucky bag (ETF)."

3. People at investment banks, not the ETF company, short sell

People at investment banks and other institutions (Authorized Participants/APs) compare the stock index, such as the S&P 500, with the ETF company's PCF (the list of stocks). For example, if the ETF is being bought at a price slightly higher than the stock index, they short sell that ETF.

* They check how much each individual item inside the lucky bag (ETF) is actually worth. If the lucky bag (ETF) is 500 yen, but the total value of the contents is actually 300 yen, they realize the lucky bag (ETF) has a 200 yen premium, meaning it is being sold at too high a price, so they short sell it.

4. People at investment banks, not the ETF company, buy the individual stocks

People at investment banks and other institutions buy the individual stocks listed in the PCF (the list of stocks).

* They buy each item inside the lucky bag (ETF) at its actual price one by one.
If you buy it as a lucky bag, it costs 500 yen, but if you buy them separately one by one, you can get them for a total of 300 yen.

5. People at investment banks, not the ETF company, have the purchased individual stocks turned into an ETF

People at investment banks and other institutions take the individual stocks they bought from the PCF (the list of stocks) to a trust bank and have them turned into an ETF.

* By taking the items they bought separately for 300 yen and having them turned into a lucky bag (ETF), they create a 300 yen lucky bag (ETF) with the exact same contents as the original lucky bag (ETF).

6. People at investment banks, not the ETF company, buy back the shares

They buy back the ETF they shorted in step 3.

*Since a 300 yen lucky bag (ETF) has been created, buying back the initial 500 yen lucky bag (ETF) results in a 200 yen profit.

7. Repeat steps 1 through 6 every day.

As described above, the act of selling an ETF when it is expensive and buying it when it becomes cheap to make a profit (arbitrage) is repeated every single day, and that is how the ETF price is determined.

In other words, the price of a certain ETF does not rise because it is bought in large quantities, nor does it rise simply because demand is high.